Commentary and musings on the complex, fascinating and peculiar world that is securities regulation

Tuesday, April 03, 2012

Legislation Exempting Inter-Affiliate Swaps from Dodd-Frank Has Important Protections and Risk Management Features

Legislative history indicates that the bi-partisan legislation passed by the House to exempt inter-affiliate swaps from derivatives regulation under the Dodd-Frank Act contains important protections and helps companies mitigate risk. H.R. 2779 preserves the important reforms of the over-the-counter swap markets enacted as part of Dodd-Frank while providing swap end users with an exemption that is responsive to their legitimate business needs for flexibility, risk management, and price stability. (Rep. Gwen Moore (D-WI), Cong. Rec. (Mar 26, 2012 p. 1550). Without the relief provided by HR 2779, companies would face the prospect of having to post double margins on swap trades: once on a swap trade with themselves and secondly when they trade outside

Rep. Scott Garrett (R-NJ) noted that under H.R. 2779 the inter-affiliate trades would be only exempt from costly margin, clearing, and real-time reporting requirements. Swap trades facing non-affiliated counterparties would still be subject to all the other regulatory requirements. (Cong Rec. (Mar 26, 2012) p. H 1549). A co-sponsor of the legislation, Rep. Steve Stivers (R-OH) said that HR 1779 contains important protections to ensure that businesses using the exemption are truly affiliated. The measure also ensures that there will be reporting requirements so that these swaps adhere to transparency in the marketplace. HR 2770 clarifies that any attempt to use these provisions to evade provisions under the Dodd-Frank Act for someone who is just trying to evade the law and does not have true inter-affiliate swaps would not be allowed. The legislation further ensures that regulators keep their authority to manage the safety and soundness of financial institutions. (Cong Rec. (Mar 26, 2012) p. H1550)

Thus, the measure provides the relief and at the same time strengthens the ability of the regulators to oversee the affiliate swaps marketplace because those transactions must be reported still to a swap depository, or the CFTC or the SEC. Either way, regulators will be able to monitor these transactions very closely. HR 2779 also gives the SEC and CFTC the power to regulate swap transactions that are structured as affiliate trades only for purposes of evading regulation. Garrett

The Dodd-Frank Act addressed the lessons of the financial crisis by pushing as many product types as possible to be centrally cleared and traded on electronic exchanges or other trading facilities, subjecting these swap dealers and major market participants to capital and to margin requirements, and requiring the public reporting of transaction and pricing data of both cleared and uncleared swaps. Rep. Moore assured that H.R. 2779 does not disturb any of those important reforms accomplished in Dodd-Frank. Inter affiliate swaps are simply transactions within a single group of affiliated entities, in other words, meaning entities that prepare financial statements on a consolidated basis. Therefore, inter affiliated swaps do not add or subtract from overall systemic risk. (Cong Rec. (Mar 26, 2012, p. H1550)

Through the process of drafting the bill, a number of revisions were adopted. The definition of ‘‘control,’’ which is central to the issues of a legitimate inter affiliate transaction, was clarified. Anti-evasion measures were added so that the exemption would not lead to abuse. Language was adopted that made sure the Fed authority over inter affiliate banks was preserved as was language that clearly and explicitly states that the bill does nothing to disturb the existing regulatory regime for insurance companies.

Under the Dodd-Frank financial reform law, there is no distinction between inter-affiliate and external swaps. HR 2779 clarifies the Dodd-Frank Act by recognizing that there is an important distinction between inter-affiliate swaps and market-facing swaps. HR 2779 recognizes that the regulation of inter-affiliate trades should reflect the economic reality that internal trades do not increase systemic risk. Thus, the legislation exempts derivatives trades between two affiliates of the same corporation from clearing, execution, and margin requirements. It would prevent internal, inter-affiliate swaps from being subject to requirements that were designed to apply only to certain external swaps. These internal swaps are used by many corporations in multiple sectors of the economy.

Rep. Stivers explained that, while market-facing swaps carry risk, inter-affiliate swaps do not. They are simply an accounting practice used within corporate families to assign the ownership of derivatives inside the corporate umbrella. Without providing this distinction, corporations using inter-affiliate swaps that manage their risk in a central way would be forced to pay up to three times for the way they do business. In fact, they would collateralize their derivatives against the market on one side and then on both sides of the inter-affiliate swap, so they would actually pay three times what would be paid if entity didn’t manage its risk in a centralized way. The irony of that is, in managing risk in a centralized way, it actually provides better protection and allows for experts to manage risk. (Cong Rec. (Mar 26, 2012) p. H1550)

Rep. K. Michael Conaway (R-TX), Chair of the House Commodities and Risk Management Subcommittee, observed that inter affiliate swaps between entities within a single corporate structure are an important tool for companies and to manage their risk. Centralizing a large organization’s risk mitigation efforts can yield substantial economic benefits and reduce a firm’s overall credit risk. In addition to creating operating savings through economies of scale, these companies can also reduce the number of external facing transactions altogether. By looking at a firm’s entire risk portfolio, explained the oversight Chair, it is possible to find places where risks overlap and offset one another, reducing the need for entering the market. Fewer swaps mean less money tied up in margin, clearing, and execution and more money being spent on hiring, buying supplies, and funding innovation. (Cong Rec. (Mar 26, 2012) p. 1550)

Similarly, Rep. Moore noted that swaps are versatile financial tools that have become instrumental for the management of risk and for allowing companies to more efficiently transact in global markets. Swaps aid companies to hedge and to mitigate things like interest rate and currency exposure, but also more exotic risks associated with unique markets and businesses. H.R. 2779 clarifies that end users, not investors, have the ability to hedge risk for legitimate business purposes. The flip side of swaps are that they may also be used to acquire risk by investors. In that capacity, swaps allocate risk to parties that want to and are able to bear the risk. However, in the unregulated pre-Dodd-Frank world, over-OTC swaps and derivatives lacked transparency and allowed risk to pool and gather in ways that would eventually help drive the financial crisis and create systemic risk. (Cong Rec. (Mar 26, 2012) p. 1550)

Rep. Conaway also posited that HR 2779 offers businesses and agriculture firms certainty about a small but important aspect of Dodd-Frank. Left untreated, ambiguity in Dodd-Frank could undo innovative risk management strategy. If inter affiliate swaps are treated the same as other swaps, end users could wind up posting margin for the same swap twice: once for the public trade and once for the internal trade that assigns the swap to the appropriate business unit. He reasoned that posting margin for the same transaction twice would cause companies to abandon the use of inter affiliate swaps altogether and, with it, the efficiencies that made the strategy attractive in the first place, thereby driving up their business costs and overall risks. (Cong Rec. (Mar 26, 2012) p. 1550)